How to cash in your funds (and not take a tax bath)
Ready to cash in on an exchange-traded fund?
When you see the market price of the fund you’re holding climb, it may be that the time is right to pull the trigger on a sale. But before you do so, it’s important to know your way around the tax rules that apply to income from ETFs.
In this posting, the final installment of Wall Street Survivor’s five-part series on exchange-traded funds, we’ll look at how the money you stand to make gets taxed, and in the process you’ll be able to pick up a few tips about how to control your exposure to that process. So read on before you pull the trigger finger.
Capital Gains and the ETF
Capital. Gains. Two words that speak volumes when it comes to ETF taxation.
At its simplest, capital gains is a term that describes how much you make when you sell a stock. To figure it for a single share, take the sales price and subtract all the fees, commissions, and the original purchase price from that amount.
For example, if you bought a share of Parvex Wheat — a fictional company — for $39 and you paid $5 in fees, and $1.50 in commissions, and then you sold it for $48, your capital gain would be $2.50. ($48-$39=$9, and then $9-$6.50=$2.50.)
The “taxman” (or IRS) looks at capital gains when it assesses how much income your investments have created. As you get into funds of different kinds, the agency’s accountants look at capital gains in different ways. It can get complex pretty quickly when it comes to assets like mutual funds, but the way exchange-traded funds are taxed can be broken down into the following relatively straightforward events.
1. End-of-Ownership Taxation:
Unlike other kinds of funds that can trigger capital gains taxes whenever shares are sold for a profit, ETFs work differently. The government considers everything that is moved around within an ETF to be an “in-kind activity”, not a profit-making move. The upshot is that profit is only taken into consideration when you sell your stake in the fund. At that point, capital gains tax does come into effect, manifesting in one of the two following ways.
- Long-Term: If you’ve owned your exchange-traded fund for longer than 1 year, expect to pay long-term capital gains tax. This is often a discounted rate.
- Short Term: Hold the ETF for less than a year, and you’re paying what is likely to be the non-discounted, short-term capital gains tax.
2. Dividend Taxation
Note that if the shares in your ETF pay out dividends during the time you own it, you’ll typically have to pay taxes on that income in the ordinary fashion.
If you’re unclear on what a dividend is, check out this great video!
Exceptions: ETFs and Sectors
There are a few kinds of exchange-traded funds that can prompt different tax treatment. These are metals, currencies, and futures.
Silver and gold (and other precious elements) often fall under the IRS’s category of collectibles. Short-term holdings of these things are treated in the same way as any other kind of fund, but when it comes to long-term capital gains, you’ll want to check with the ETF’s operators to find out what kind of tax rate applies to the metal in question.
There are no long-term discounts on these kinds of funds.
These are assets that represent contracts; an agreement to buy something at a set price down the road. The contracts are then traded based on the price they bear (speculators are, in a sense, then, trying to beat the agreed-upon price). What you need to know about futures when it comes to ETFs is that the tax rate is 40% on short-term gains and 60% on long-term. And if you’re holding the fund at the end of the market year, you’ll get taxed on unrealized gains (that is, the value of the shares regardless of whether you’ve cashed them in).
Armed with information, you can now step into the world of exchange-traded funds. From understanding what they are, to buying them, to strategizing how to use them and how to take care when it comes to tax time, you’re one step closer to being a savvy Wall Street Survivor. Until next time: good luck, investors!